Buying an Existing Business

5 minute read

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Maybe you’ve already
owned or operated a small business. Perhaps this is your first. Sure, you have
to review the numbers. But what else is important when buying an existing
business? What are the best practices that a prospective business purchaser
should consider before buying an operational firm? What kind of legal,
financial and tax issues are important before signing on the dotted line?

No Guarantees: Do Due
Diligence

Jeff Veigel, co-owner
of Isles Buns & Coffee in Minneapolis, Minn., has been down that road
before. Veigel said there are no guarantees when purchasing an existing
business. “You have to perform due diligence, explore the financials and
believe you can do as well or better than the previous owner,” Veigel said.

For people owning
their first business, buying an existing entity can save a tremendous amount of
money.  “It is already established and
has a stream of revenue you can use to pay down the cost of purchasing the
business. There is some security that, after looking at the books and its
history, inspecting the physical plant and customer lists, you can determine
that you can make a living from that,” he said.

He advised
prospective owners to conduct information searches or hire an attorney to
insure there are no unknown debts they would inherit, no pending lawsuits, and
that all liability and assets are disclosed. “Check with the city and state to
make sure there are no unpaid sewer access fees and that the county isn’t
planning to close your street for construction for the next six months,” he
said. “And make sure there are no lingering workmen’s compensation issues, that
the previous owners have paid overtime and employee taxes. Most of this you can
find in public records.”

What is Important?

Daniel Pierce, a transactional attorney with the Boston office of
the law firm, Duane Morris, said owners should think about the parts of the business
most important to them. “Intangibles can be difficult to get a fix on,” Pierce
said. “But they can be very valuable and sometimes the entire reason for the
purchase. So if this is a service or a business with a strong service component,
be sure that is addressed.”

For example, he said, customer lists might be the crown jewel
among the assets that the buyer is seeking. They must make sure assets like
that are included in the purchase.” Pierce also said it’s worth exploring the
kinds of protections offered.

“How easy is it for the buyer to terminate those contracts after the
sale if things aren’t as promised on day one in the financial reports? Are the
numbers the buyer is looking at dependent upon favorable terms, such as a lease
rate that may not be available to you?” He also advised consulting a tax
specialist in the early stages of negotiations.

“Typically buyers want to buy the assets of the business and limit
their exposure to pre-existing conditions, to pick and choose the liabilities
they want to accept, while sellers want to sell the stock of their companies so
they can get the benefit of capital gains treatment. There may be unpaid taxes
or unfunded pensions. Taxes are often big drivers of these deals, and how they
are structured matters.”  He said buyers
should also explore potential environmental liability, particularly
manufacturers or companies dealing with hazardous waste products, petroleum or chemicals.
“As a buyer you may be picking up that liability,” he cautioned.

Ed Culhane, a partner and managing director for the Boston office
of the accounting firm, Andersen Tax, advised prospective buyers to examine the
company books and records. “Anyone who wants to buy a company wants to see a
dashboard and solid financials. They should ask questions and request revenue
projections and solid business plans without having to wait three months,”
Culhane said.

From the legal side make sure the “know how”—intellectual
property, proprietary technology or secret recipe– is contractually protected.
“Get a good attorney to make sure your corporation documents and stock
agreements are covered.” And be sure that the valuation is performed by an
experienced professional, not on the word of the seller’s Uncle Joe.

No False Confidence

David  Coffman, president and CEO of Business
Valuations & Strategies based in Harrisburg, Pa., cautioned prospective
buyers to do some serious soul-searching first. “Often it’s someone coming off a
successful corporate career that did well there and has a false sense that they
know what they’re doing. But most have never run a small business, even if they
operated in the same industry where they worked during their corporate careers.
Because of this false confidence they often end up spending way too much
money.”

Coffman said before
buying into an existing business, study that industry or market, contact trade
association and peruse industry publications.  “Talk with people in that business. And give
yourself time. Don’t rush into it. Define what you’re looking for.”

While intangibles
like longstanding geographic location, good will and lists of longtime loyal
customers may add value, he said finding the true worth of a business is basic.
“Show me the money,” he said. “If it’s not generating profits, it’s not worth
it. If you can’t convert these intangibles into cash flow, how will I do it?
Never ever pay for potential. Buy the business as it is now.”

David Velasco, president of Denver,
Colo.-based Strategic Valuation Associates, said obtaining an accurate
financial history of a company is vital to any prospective buyer. “It should
raise red flags if owners don’t provide tax returns. Lacking that information
is like making a projection off of a single data point: you need the context of
history.”

Velasco said the most
common mistake new business buyers make is overestimating revenues and
underestimating expenses. “Most businesses fail because they didn’t deliver
financially on the original estimates of the company’s value,” he said.

Early in the process
the prospective owner must decide how to operate the company. Will the owner
manage the business, or hire a professional manager and act as a financial
investor. “That helps determine the cost structure. Most people who buy in are
looking to get a paycheck plus build value for their long term retirement. So
if they’re going to work in their own company, it must return a fair share.”

He recommended
contacting a transactions attorney to put together the deal, submit the terms
sheet, create a definitive purchasing agreement and, if there are multiple
investors, create a shareholders’ agreement. 

Motivations

Velasco said understanding
the motivation of the seller is vital to establishing the negotiating range. “If
you don’t understand that motivation and you want to play Donald Trump
hardball, the sellers may tell you to take a hike,” he said. “For many owners,
that small business is their baby, their bread and butter, and they want to
make sure it’s well cared for. If you understand motivation, whether it’s
impending retirement, financial distress, or something else, that could help
close the deal.”

Lori Mize, director
of the Tampa, Fla.-based online small and mid-size business valuation firm,
Peer Comps, said there are many risk factors prospective owners need to
consider. “Has the company’s performance been consistent? If not, why not? What
about intangibles like customer loyalty? You might be buying a dentist’s
practice, but his patients are loyal and may not stay with you. And consider
customer concentration. If you’re a distribution company and one customer
comprises 90% of the business, if that person goes, so does the business. So
you want to have those commitments confirmed.”

Mize said there are
diversification risks with customers, suppliers, parts and services, all of
which could impact the value of the business. “Are you buying into an obsolete
or soon to be obsolete industry? “Remember video stores?” she reminded.